“It also confirms the early warning over weakening end-user demand given by developments in the global chemical industry since the start of the year. Capacity Utilisation was down again in September as end-user demand slowed. And this pattern has continued into early November, as shown by our own Volume Proxy.”

The same phenomenon had occurred before the 2008 Crisis, of course, as described in The Crystal Blog. I wrote regularly here, in the Financial Times and elsewhere about the near-certainty that we were heading for a major financial crisis. Yet very few people took any notice.

So why did Apple shares suddenly crash 10% on 3 January, as the chart shows? Everything that Apple reported was already known. After all, when I wrote in November, I was using published data from Strategy Analytics which was available to anyone on their website.

The answer, unfortunately, is that markets have lost their key role of price discovery. Central banks have deliberately destroyed it with their stimulus programmes, in the belief that a strong stock market will lead to a strong economy. And this has been going on for a long time, as newly released Federal Reserve minutes confirmed last week:

The result is that few investors now bother to analyse what is happening in the real world.

They believe they don’t need to, as the Fed will always be there, watching their backs. So “Bad News is Good News”, because it means the Fed and other Western central banks will immediately print more money to support stock markets.

And there is even a new concept, ‘Modern Monetary Theory’ (MMT), to justify what they are doing.

THE MAGIC MONEY TREE PROVIDES ALL THE MONEY WE NEED

There are 3 key points that are relevant to the Modern Monetary Theory:

The Federal government can print its own money, and does this all the time

The Federal government can always roll over the debt that this money-printing creates

The Federal government can’t ever go bankrupt, because of the above 2 points

The scholars only differ on one point. One set believes that pumping up the stock market is therefore a legitimate role for the central bank. As then Fed Chairman Ben Bernanke argued in November 2010:

“Higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”

“MMT logically argues as a consequence that there is no such thing as tax and spend when considering the activity of the government in the economy; there can only be spend and tax.”

The result is that almost nobody talks about debt any more, and the need to repay it. Whenever I talk about this, I am told – as in 2006-8 – that “I don’t understand”. This may be true. But it may instead be true that, as I noted last month:

“Whilst Apple won’t go bankrupt any time soon, weaker companies in its supply chain certainly face this risk – as do other companies dependent on sales in China. And as their sales volumes and profits start to fall, investors similarly risk finding that large numbers of companies with “Triple B” ratings have suddenly been re-rated as “Junk”:

Bianco Research suggest that 14% of companies in the S&P 1500 are zombies, with their earnings unable to cover interest expenses

The Bank of International Settlements has already warned that Western central banks stimulus lending means that >10% of US/EU firms currently “rely on rolling over loans as their interest bill exceeds their EBIT. They are most likely to fail as liquidity starts to dry up”.

I fear the coming global recession will expose the wishful thinking behind the magic of the central banks’ money trees.

Chemicals are easily the best leading indicator for the global economy. And if the global economy was really in recovery mode, as policymakers believe, then the chemical industry would be the first to know – because of its early position in the value chain. Instead, it has a different message as the chart confirms:

It shows changes in global production and key sectors, based on American Chemistry Council (ACC) data

It highlights the rapid inventory build in H2 as oil and commodity prices soared

But since then, all the major sectors have moved into a slowdown, and agchems into decline

As the ACC note:

“The global chemical industry ended the first quarter on a soft note. Global chemicals production fell 0.3% in March after a 1.0% drop in February, and a 0.6% decline in January. The last gain was 0.3% in December.”

This, of course, is the opposite of consensus thinking at New Year, when most commentators were confident that a “synchronised global recovery” was underway. It is therefore becoming more and more likely, as I warned in January, that policymakers have been fooled once again by the activities of the hedge funds in boosting “apparent demand”:

“For the last 6 months, everyone who buys oil or other commodity-related products has been busy building as much inventory as they could afford. In turn, of course, this has made it appear that demand has suddenly begun to recover. At last, it seems, the “synchronised global recovery” has arrived.

“Except, of course, that it hasn’t. The hedge funds didn’t buy 15 days-worth of oil to use it. They bought it to speculate, with the OPEC-Russia deal providing the essential “story” to support their buying binge.”

This downturn is worrying not only because it contradicts policymakers’ hopes, but also because Q1 volumes should be seasonally strong:

Western companies should be restocking to meet the surge of spring demand

Similarly, China and the Asian markets should now be at peak rates after the Lunar New Year

HIGHER OIL AND COMMODITY PRICES ARE CAUSING DEMAND DESTRUCTION
The problem is that most central bankers and economists don’t live in the real world, where purchasing managers and sales people have bonuses to achieve. As one professor told me in January:

“Economists would tend to be skeptical about concepts such as “apparent demand”. Unless this a secret concept (and it doesn’t seem like it is), other investors should also use it, and then the oil price should already reflect it. Thus, there wouldn’t be gains to be made (unless you’re quicker than everyone else or have inside information)…”

But in the real world, H2’s inventory build has now been replaced by destocking – whilst today’s higher oil prices are also causing demand destruction. We have seen this many times before when prices have risen sharply:

Consumers only have limited amounts of spare cash

When oil prices jump, they have to cut back in other areas

But, of course, this is only confirmed afterwards, when the spending data is reported

Essentially, this means that policymakers today are effectively driving by looking in the rear-view mirror

RISING DEBT LEVELS CREATE FURTHER HEADWINDS FOR GROWTHNew data from the US Federal Reserve Bank of St Louis also highlights the headwinds for demand created by the debt build-up that I discussed last week. As the chart shows:

US borrowing was very low between 1966-79, and $1 of debt created $4.49 in GDP growth

Borrowing rose sharply in the Boomer-led SuperCycle, but $1 of debt still created $1.15 in GDP growth

Since stimulus programmes began in 2000, however, $1 of debt has created just $0.36 of GDP growth

In other words, value destruction has been taking place since 2000. The red shading tells the story very clearly, showing how public debt has risen out of control as the Fed’s stimulus programmes have multiplied – first with sub-prime until 2008, and since then with money-printing.

RISING INTEREST RATES CREATE FURTHER RISKS
Last week saw the yield on the benchmark US 10-year Treasury Bond reach 3%, double its low in June 2016. It has risen sharply since breaking out of its 30-year downtrend in January, and is heading towards my forecast level of 4%.

Higher interest rates will further slow demand, particularly in key sectors such as housing and autos. And in combination with high oil and commodity prices, it will be no surprise if the global economy moves into recession.

Chemicals is providing the vital early warning of the risks ahead. But as usual, it seems policymakers prefer to wear their rose-coloured spectacles. And then, of course, as with subprime, they will all loudly declare “Nobody could have seen this coming”.

Instead of simply boosting demand, as during the 1960s-1970s, they began to work and create new supply

This meant supply/demand began to rebalance and interest rates then peaked at 16% in 1981

By 1983, the average Western Boomer (born between 1946-1970) had arrived in the Wealth Creator cohort, which dominates consumer spending, and the economy really began to hum. There was a final inflation scare in 1984, when US inflation suddenly jumped from 3% to 5%, but after that the trend was downwards all the way.

The Boomers were the largest and wealthiest generation that the world had ever seen. Their move to become Wealth Creators completely transformed the inflation outlook, as more and more Boomers joined the workforce. And they transformed the economy by moving it into the NICE era of Non-Inflationary Constant Expansion.

Central bankers took credit for this move, claiming it was due to monetary policy. But in reality, people are the key element in an economy, not monetary policy. You can’t have an economy without people. And sadly, the idea that the US Fed Chairman Alan Greenspan had somehow become a Maestro, blinded everyone to 2 key issues for the future:

Life expectancy was rising rapidly, meaning that the Boomers would not normally die just after retirement. Instead, they would likely live for another 15 – 20 years after reaching age 65

This combination of a rise in life expectancy and a collapse in fertility rates was creating a timebomb for the economy.

THE RISE IN LIFE EXPECTANCY AND COLLAPSE OF FERTILITY RATES CREATED AN ECONOMIC TIMEBOMB

Western economies are based on consumer spending. And spending declines once people reach the age of 55 – they already own most of what they need, and their incomes decline as they approach retirement, as the second chart shows:

There were 65m US Wealth Creator households in 2000, who spent an average of $62k ($2017)

There were only 36m in the 55+ cohort, who spent just $45k each

In 2017, there were 66m Wealth Creators (almost the same as in 2000) who spent $64k each

But there were now 56m in the 55+ cohort, who spent just $51k each

The rise in 55+ spending was also only temporary, as large numbers of Boomers have just reached 55+ and have not yet retired. Spending by those aged 74+ was down by nearly 50% versus the peak spending 45-54 age group.

BELIEF IN MONETARISM LED TO THE DOTCOM AND SUBPRIME DISASTERS
The dot-com crash in 2000 should have been a wake-up call for the failure of monetarism. It also, after all, marked the moment when the oldest Boomers began to join the 55+ cohort. But instead, policymakers thought monetarism could solve “the problem” and cut interest rates to boost the housing market – causing the subprime crash in 2008.

One might have thought – as we wrote in Boom, Gloom and the New Normal in 2011 – that this disaster would have destroyed the monetarism myth. But no. Abandoning monetarism would have led to a difficult conversation with voters about the need for everyone to retrain in their 50s, and prepare to take on new, and less physically demanding, roles.

Instead, policymakers tried to replace lost BabyBoomer demand by printing vast amounts of free money via the Quantitative Easing and Zero Interest Rate Policies. Their aim was to avoid deflation, as inflation had fallen to just 0.6% in 2010 – although why this was a “bad thing” was never explained. But in reality, they were running uphill, and the pace of the climb was becoming more vertical, as the average Western Boomer joined the 55+ cohort in 2013.

Of course, flooding the market with cheap money boosted asset prices, as they intended. Stock markets and house prices soared for a second time. But it also created a major new risk. More and more investors began to panic as they hunted through the markets, trying to obtain a decent “return on capital”. They assumed central banks would never let markets fall, and so gave up worrying about the risk of making a dud investment.

INTEREST RATES ARE NOW HEADED HIGHER AS PEOPLE WORRY ABOUT RETURN OF CAPITAL
The end of the Bitcoin bubble has highlighted the fact that that risk and reward are normally related. Most investments that offer potentially high rewards are also high risk – a lot has to go right, for them to make the possible return. This process of price discovery – the balance of risk and reward – is the key role of markets.

Left to themselves, markets will price risk properly. But they have been swamped for the past decade by central bank liquidity and their crucial role has been temporarily destroyed. Now, the fact that the US 10-year bond has broken out of its 30-year downtrend tells us that markets they are finally starting to regain their role.

How high will interest rates now go? We cannot yet know, and we can also be sure they will not move in a straight line as central banks will continue to intervene. But as more and more investments, like Bitcoin, prove to be duds, so more and more investors will start to worry about return of capital when they invest.

4% therefore looks like the next level for rates, as we are now trading within the blue bars on the chart. It may not take very long for this level to be reached, given the fact that the world now has a record $233tn of debt – 3x the size of the global economy. After that, we shall have to wait and see.

FORECAST MONITORINGI strongly believe that forecasts should be monitored, which is why I always review the previous Annual Budget forecast before issuing the next Outlook, and always publish the complete list of Annual Budget Outlooks.

I now plan to begin monitoring my blog forecasts, using the percentage mechanism highlighted in Philip Tetlock’s masterly “Superforecasting” book. The first forecasts relate to last week’s post on US polyethylene exports and today’s forecast for the US 10-year Treasury bond. I will change confidence levels as and when circumstances change.

Stock markets used to be a reliable indicator for the global economy, and for national economies. But that was before the central banks started targeting them as part of their stimulus programmes. They have increased debt levels by around $30tn since the start of the Crisis in 2008, and much of this money has gone directly into financial markets. Today, Japan is a great example of the distortions this has produced, as the Financial Times reports:

□ The Bank of Japan (BoJ) has been buying stocks via its purchases of Exchange Traded Funds (ETFs) since 2010
□ Last July, it doubled its purchases to ¥6tn of ETFs($58bn) per year, focused on supporting Abenomics policy
□ Analysis by Japanese bank Nomura suggests its purchases have since boosted the Nikkei Index by 1400 points

Even more importantly, the BoJ is particularly active if the market looks weak. Between April 2013 – March 2017, it bought on more than half of the days when the market was down.

The distortion ins’t just limited to direct buying by the BoJ, of course. It is magnified by the fact that everyone else in the market knows that the BoJ is buying. So going short is a losing proposition. Equally, investors know that the BoJ is guarding their back – so they are guaranteed to win when they buy.

This manipulation by the BoJ is just an extreme form of the intervention carried out by all the central banks. It means that the stock market has lost its role as an indicator of the economy. And so all those models which include stock market prices in their calculations are also over-optimistic.

This is why the global chemical industry has become the best real-time indicator for the real economy. As I noted back in January, it has an 88% correlation with IMF data for global growth – far better than any other indicator:

“The logic behind the correlation is partly because of the industry’s size. But it also benefits from its global and application reach. Every country in the world uses relatively large volumes of chemicals, and their applications cover virtually all sectors of the economy, from plastics, energy and agriculture to pharmaceuticals, detergents and textiles.”

Latest data on Capacity Utilisation (CU%) from the American Chemistry Council is therefore very worrying, as the chart shows:

□ Since 2009, the CU% has never recovered even to the 1987 – 2008 low of 86.4%
□ It has been in a downward trend since January 2016, when it peaked at 81.4%
□ April’s CU% fell to 79.9% versus 80.7% in April last year
□ This was very close to the all-time low of 77% seen in March 2009

The problem is that central banks have moved from the pragmatism of the 1980s to ideology. They have become, in Keynes’s famous phrase “slaves to some defunct economist” – in this case, Milton Friedman and Franco Modigliani, as we argued in our evidence earlier this year to the UK House of Commons Treasury Committee:

“Friedman’s analysis of the effectiveness of monetary policy, when he argued that “inflation is always and everywhere a monetary phenomenon”, is therefore no longer valid. Modigliani’s “Life Cycle theory of consumption” is similarly out of date. … Friedman and Modigliani’s theories appeared to make sense at the time they were being developed, but they clearly do not fit the facts today.”

Instead of the promised economic growth, the central banks have in fact simply piled up more and more debt – which can never be repaid. 2 years ago, the global total was already $199tn, and 3x global GDP, according to McKinsey. Just in the US, this means net interest payments will cost $270bn this year, and total $1.7tn over the next 5 years, according to the impartial Congressional Budget Office.

Stock markets may continue in their optimistic mode for a while longer. But in the end, the lack of promised growth will force the central banks to stop printing money. They will then have to abandon their ideological approach, and instead accept the common sense argument of our Treasury Committee evidence:

“Monetary policy should no longer be regarded as the key element of economic policy. This would then free policymakers to focus on the real demographic issues that will determine growth in the future – namely how to encourage people to retrain in their 50s and 60s to take advantage of the extra 20 years of life expectancy that we can all now hope to enjoy.”

Monetary policy used to be the main focus for running the economy. If demand and inflation rose too quickly, then interest rates would be raised to cool things down. When demand and inflation slowed, interest rates would be reduced to encourage “pent-up demand” to return.

After the start of the Financial Crisis, central banks promised that lower interest rates and money-printing would have the same impact. They were sure that reducing interest rates to near-zero levels would create vast amounts of “pent-up demand”, and get the economy moving again. But as the chart shows for US GDP, they were wrong:

□ It shows the rolling 10-year average for US GDP since 1950, to highlight longer-term trends
□ It confirms the stability seen between 1983 – 2007 during the BabyBoomer-led economic SuperCycle
□ The economy suffered just 16 months of recession in 25 years, as monetary policy balanced supply and demand
□ But the trend has been steadily downwards since 2008, despite the record levels of stimulus

The clear conclusion is that monetary policy is no longer effective for managing the economy.

 It was clearly important until 2000, when the great majority of people were in the Wealth Creator 25 – 54 age group (which dominates consumption and therefore drives GDP growth). But its impact is now declining year by year as more and more BabyBoomers move into the 55+ age group – when incomes and spending begin to decline quite rapidly
 Friedman’s analysis of the effectiveness of monetary policy, when he argued that “inflation is always and everywhere a monetary phenomenon”, is therefore no longer valid. Modigliani’s “Life Cycle theory of consumption” is similarly out of date
 The issue is simply that both Friedman and Modigliani were working in an environment which assumed that people were born, educated, worked – and then died soon after reaching pension age. In these circumstance, their theories were perfectly valid and extremely useful for modelling the economy
 Today, however, the rapid increase in life expectancy, together with the collapse of Western fertility rates below replacement level, means that a paradigm shift has taken place. People are now born, educated, work – and then continue to live for another 20 years after retirement, before dying
 The essential issue is that “you can’t print babies”. Monetary policy cannot solve the demographic challenges that now face the UK (and global) economy
 We therefore hope that the Committee will conclude that monetary policy should no longer be regarded as the major mechanism for sustaining UK growth

“Will economists start to consider demographics when making their forecasts and developing government policies?”

This was the question on my mind at a recent discussion on the topic of “An economy that works for everyone” at the UK’s Institute for Government. The speaker was the Chief Economist of the Bank of England, Andy Haldane, and the Institute’s Director, Bronwen Maddox kindly invited me to ask my question as part of the discussion. You can watch the Q&A by clicking here. The transcript is below.

Critically, Haldane acknowledges that economists need to rethink their approach. Until now, they have focused on developing policies that impact “the average person”. Instead, he agrees that they now “need to be super-granular, household by household”, in terms of demographics and other relevant detail.

Paul Hodges
“Andy. Thank you very much indeed for the stimulating talk. You made a comment just now about “is it something else” (that is causing the post-2008 recovery to be so slow and uncertain), and at the start you talked about the need perhaps to reinvent or rethink economics. You also made a point about the failure of conventional economics to explain this difference between the frontier companies (who are leading in their fields) and the others.

Just before Christmas the bank put out a survey of spending with relation to interest rates and monetary policy which suggested that again and I quote almost exactly “conventional economics would have said that if you pass on lower interest rates, people will spend more. “But in fact only 10% of people did. So what I wanted to ask you was,

“Is this something else” to do with really significant demographic changes in the economy – that we now have a group of BabyBoomers, the largest-ever group of people in the population, who are refusing to die at 65 as they would have done in the past. In fact they are living now for another 20 years, and we have around one in five of the population in that age group.”

My question really is therefore “do you think that investigating this demographic impact, which has never happened before in the world, could be useful”? Because I think that it might provide the key (a) to the new type of economics and also (b) to the question of how we raise UK productivity.

Andy Haldane“Paul, your work on this is a very good example of how demographics in mainstream economics has been under-emphasized for too long.

That I think is changing by the way – that I think is changing and we are seeing for example when people tell the story that I mentioned earlier on about secular stagnation – the kind of Bob Gordon, Larry Summers-type hypothesis – one of the facts that is pointed towards would be demographic factors nudging us in that direction.

When we’re trying to make sense of why it is that interest rates globally – not ones set by central banks, ones set by financial markets – why they are so low, for as far as the eye can see, part of the explanation, I think, lies in evolving demographics and the implications that has about saving and for investment.

The study you mention, I think of households, which we conduct a regular basis to try and understand their patterns of spending and saving is, in some ways, a brief example of all we discussed today. It’s a vertical distribution. It’s saying we can’t take the average person, the so-called representative agent and hope that by studying them we can make sense of what’s going on. We need to be super-granular, household by household:

 Conditioning on whether they are a borrower or a saver, whether they are young or whether they are old, whether they live in the North East or whether they live in the South West And using that to condition our policy responses including our monetary policy responses

It could be the case we reach the point where interest rates are a bit less potent in stimulating spending than was the case in the past. We shouldn’t have fixed views or fixed multipliers about how monetary policy works.

It can change as the economy can change and by looking at this more granular data, like Michael Fish* did after 1987, we can perhaps tomorrow, or failing that the day after tomorrow, do a somewhat better job of making sense of what happens next in the economy.”

* Michael Fish was the BBC weather forecaster who famously denied on-air in October 1987 that a hurricane was about to hit the UK. Haldane had earlier noted that this failure had prompted a complete rethink of weather forecasting, which was now much better as a result. He hoped that economists’ failure to forecast the 2008 Crisis might end up causing a similar process of rethinking and reinvention to take place.